Incremental Analysis

CONCEPT OF RELEVANCE: Information must be associated with the decision or question under
consideration in order for the information to be relevant. Information can be based on past or present data,
but it can be only be relevant if it pertains to a future decision.

Relevant costing is an approach that focuses managerial attention on a decision’s relevant facts.
A differential cost is a cost that differs between or among the various decision alternatives. A cost must
be differential to be relevant.
Incremental cost is the additional cost of producing or selling a contemplated quantity of output.
Incremental cost can be either variable or fixed. Most variable costs are relevant while most fixed
costs are not relevant.
Incremental revenue is the additional revenue resulting from a contemplated sale or provision of a service.
The difference between the incremental revenue and incremental costs of a particular alternative
is the positive or negative incremental benefit of that course of action.
Management can compare the incremental benefits of various alternatives to decide on the most
profitable or least costly alternative or set of alternatives.
Some relevant factors, such as prime product costs, are easily identified and quantified, and are
integral parts of the accounting system.
Other factors, such as opportunity costs, may be relevant and quantifiable, but are not part of the
accounting system.
An opportunity cost represents the potential benefit foregone because one course of action is chosen over
another.
Importance to Decision Maker: The need for specific information depends on how important the
information is relative to management objectives.
Sunk Costs
A sunk cost is a cost incurred in the past that is not relevant to any future courses of action.
Such a cost is the historical or past cost associated with the acquisition of an asset or a resource.
Sunk costs are not relevant to future decisions.

RELEVANT COSTS FOR SPECIFIC DECISIONS

1. Make-or-buy (outsourcing) decision is a decision that compares the cost of internally
manufacturing a component of a final product (or providing a service function) with the cost of
purchasing it from outside suppliers or from another division of the company at a specified
internal transfer price.
Variable production costs are relevant, and fixed production costs may be relevant if they can be
avoided when production is discontinued. The opportunity cost of the facilities being used by
production may also be relevant.
2. Scarce resources decisions. Scarce resources create constraints on producing goods or providing
services and can include machine hours, skilled labor hours, raw materials, and production
capacity.
3. Sales mix decisions. Sales mix is the relative combination of quantities of sales of the various
products that make up the total sales of a company. Some important factors that affect the
appropriate sales mix of a company are product selling prices, sales force compensation, and
advertising expenditures; change in one or all of these factors may cause a company’s sales mix
or shift.
4. Special order decision. It is a situation that requires management to compute a reasonable sales
price for production or service jobs outside the company’s normal realm of operations. The sales
price quoted on a special order job typically should be high enough to cover the job’s variable
and incremental fixed costs and to generate a profit.
5. Sell or continue processing. This decision requires comparison of the incremental revenue to be
provided by the product if processed further and the relevant additional processing costs. If there
is net incremental revenue, then the decision is to process the product further instead of selling it
at split-off point.
Problem 1. BBB, Inc. manufactures 100,000 units of part C5 annually, which is uses in one of its
products. The controller has collected the following cost data related to the part.

Materials 40,000
Direct labor 90,000
Variable overhead 80,000
Fixed overhead 180,000
Total costs 390,000

Carbon Company offers to supply a functionally equivalent part for P3.10 per unit. If BBB accepts the
offer, it will be able to rent some of the facilities it devotes to making the part to another company for
P20,000 annually and will also be able to reduce its fixed overhead costs by about P50,000.

Required:
1. Should BBB accept the offer?
2. What is the maximum price that BBB should be willing to pay for the part – the price that
would give it the same income it would have if it continued making it?
3. Expected use of the part might vary from the 100,000 normal level. At what annual unit
volume will BBB earn the same income making the part as it would buying it?

Problem 2. Simmons Company needs 100,000 units of a certain part to be used in production. If Simmons
Company buys the part from Sullivan Company instead of making it themselves, Simmons could not use
the present facilities for another manufacturing activity. Sixty percent of the fixed overhead applied will
continue regardless of what decision is made. The following quantitative information is available
regarding the situation presented.

Cost to make the part:

Direct materials 6
Direct labor 24
Variable overhead 12
Fixed overhead applied 15
Total 57

Cost to buy the part 53

Required:
A. In deciding whether to make or buy the part, what are Simmon’s total relevant costs to make the
part?
B. Which alternative is more desirable for Simmons?

Problem 3. The air Sole Shoe Company manufactures various types of shoes for sports and recreational
use. Several types of shoes require a build-in air pump. Presently, the company makes all of the air pumps
it requires for production. However, management is presently evaluating an offer from Aire Supply Co. to
provide air pump at a cost of P3.00 each. Air Sole management has estimated that the variable production
costs of the air pump are P2.50 per unit. The firm also estimates that it could avoid P20,000 per year in
fixed cost if it purchased rather than produced the air pumps.
a. If Air Sole requires 25,000 pumps per year, should it make them or buy them from Aire Supply
Co.?
b. If Air Sole requires 60,000 pumps per year, should it make them or buy them?
c. Assuming all other factors are equal, at what level or production would the company indifferent
between making and buying the pumps?
Problem 4. Star Sports, Inc., a manufacturer of premium boats, has just received an offer from a supplier
to provide 500 units of a component used in its main product. The component is currently produced
internally. The supplier has offered P6,000 per unit. Starflight is currently using a functional, unit-based
costing system that assigns overhead to jobs on the basis of direct labor hours. The estimated functional-
based full cost of producing the wheel assembly is:

Direct materials P3,700

Direct labor 1,000
Variable overhead 500
Fixed overhead 2,000

Prior to making a decision, the company’s CEO commissioned a special study to see whether there would
be any decrease in the fixed overhead costs. The results of the study revealed the following:

3 setups – P42,000 each (the setups would be avoided, and the total spending could be reduced by
P42,000 per setup.)
One less inspector needed, P300,000.
One less material handler needed, P270,000.
Engineering work: 615 hours, P200/hr. (Although the work decreases by 615 hours, the engineer
assigned to the assembly line also spends time on other products.)

1. Ignore the special study, and determine whether the assembly should be produced internally or
purchased from the supplier.
2. Using the special study data, repeat he analysis.

Problem 5. Tummy Company has the following cost structure for the upcoming year:
Sales (200,000 units @P25,000) P500,000
Manufacturing costs:
Variable P10 per unit
Fixed P180,000
Marketing and administrative costs:
Variable P5 per unit
Fixed P20,000
Required:
A. What is the expected level of profit?
B. Should the company accept a special order for 1,000 units at a selling price of P20 if variable
marketing expenses associated with the special order were P2 per unit? What is the incremental
profit if the order is accepted?
C. Suppose that the company received a special order for 3,000 units at a selling price of P19 with
no variable marketing expenses. What is the impact on profit?

Problem 6. Fail Company has the capacity to produce 5,000 units per year. The accounting department
has prepared the following projected income statement for the coming year for your use in making
decisions:
P80,000
Sales
Variable costs:
Manufacturing (4,000 x P5) P20,000
Marketing (4,000 x P1) 4,000 24,000
Contribution margin P56,000
Fixe costs:
Manufacturing P10,000
Marketing 8,000 18,000
Operating profit P38,000
Required:
Should the company accept a special order for 500 units at a selling price of P8?

A. Assuming that there are no variable marketing and administrative costs for this order and that
regular sales will not be affected, what is the impact of this decision on company profits?
B. Suppose that the preceding order has a one-time setup fee of P1,000. Should the special order be
accepted? Why or why not?
C. Disregarding questions A and B, suppose that regular sales would be reduced by 200 units if the
special order were accepted. What impact would this have on the company’s decision?

Problem 7. Angry Fish house buys fish from local fishermen and sell the fish to the public from its booth
at the public market. Lately, the fish house has had the number of requests smoked salmon and has
decided to investigate whether that would be a profitable item. The salmon Angry buys now costs the
company P50 per pound. Angry would have to take the new salmon to a smoke house o have it smoked,
which would increase the total cost to P75 for each pound of salmon. The salmon currently sells for P130
per pound, but would sell for P150 per pound if it were smoked?

Required:
1. Based on the facts given, would it be profitable to smoke the salmon?
2. If the cost the smoking process could be reduced by P15 per pound, would it be profitable to
smoke the salmon?

Problem 8. ABC Golf Balls produces two types of golf balls: the pro model and the tour model. The balls
are sold to retailers in cartons containing 360 balls (30 boxes containing 4 sleeves per box, with each
sleeve holding 3 balls). Both model are made using the same machines. It takes 15 minutes of machine
time to produce 360-pro model golf balls, whereas it takes 30 minutes to produce the same number of tour
balls. The difference in production time results mainly from the different materials used in construction.
The relevant data concerning two models are as follows:
Pro-Model Tour Model
Sales price per carton P500 P590
Less: Direct material 200 265
Direct labor 50 50
Variable overhead 50 75
Contribution margin P200 P200
Required machine time ¼ hour ½ hour

Required:
A. If the amount of machine time available to ABC is limited, which golf ball should be produced in
the larger quantity?
B. If the total machine time available is 110 hours per month and the demand for each model of golf
ball is 108,000 balls per month, how many of each model should be produced to maximize profit?

Problem 9. Palawan mining Company currently is operating at less than 50 percent of capacity. The
management of the company expects sales to drop below the present level of 10,000 tons of ore per
month very soon. The sales price per ton is P3,000 and the variable cost per ton is P2,000. Fixed costs per
month total P10,000,000.
Management is concerned that a further drop in sale volume will generate a loss and, accordingly, is
considering the temporary suspension of operations until demands in the metals markets rebounds and
once again rise. Over the past year, management has implemented a cost-reduction program that has been
successful in reducing costs to the point that suspending operations would reduce fixed costs by
P6,000,000 per month.
1. At what sales volume will the loss be greater or less than the shutdown cost of P4,000,000 per
month.
 2. Compare the amount of losses under each alternative if production and sales are:
a. 3,500 tons
b. 5,000 tons
c. 7,000 tons

Problem 10. Filay Company manufactures running and tennis shoes. The projected income statement
for the two products are as follows:
Running Shoes Tennis Shoes
Sales P450,000 P750,000
Less: Variable costs 270,000 300,000
Contribution margin P180,000 P450,000
Less: Direct fixed costs 200,000 220,000
Segment margin P(20,000) P230,000
Less: Common fixed costs (allocated) 50,000 75,000
Net income (loss) P(70,000) P155,000

The president of the company is considering dropping of the running shoes. However, if the line is
dropped, sales of tennis shoes will dropped by 10 percent. There is no significant nonunit-level
activity costs.

Required:
1. Should the company drop or keep the line of running shoes?
2. Assume that increasing the advertising budget by P20,000 will increase sales of running shoes
by 5 percent and tennis shoes by 3 percent. Should advertising be increased?